Fundamentals of Corporate Finance

1474 Pages·2016·94.987 MB·English

by  Stephen A. Ross, Randolph W Westerfield, Bradford D Jordan, Gordon Roberts

COVER PAGE
Page 1
Loblaw is a registered trademark of Loblaw Incorporation.
In 1919, Theodore Pringle Loblaw and J. Milton Cork opened in Toronto the first Loblaw Groceterias
store, which became today's Loblaw Company Ltd. With the concept of “self-serve” combined with
that of “cash and carry,” Loblaw expanded radically in 1920s and 1930s. By the time of the death of
one of its co-founders, Theodore Loblaw, there were over 150 stores in Ontario and more in the U.S.
In 1950, George Weston Ltd. gained a controlling interest and Loblaw officially became its
subsidiary. In the 1970s and 1980s, the company achieved huge success through introducing the
private labels No Name and President's Choice, resulting in Loblaw becoming Canada's largest
supermarket. Next, the company extended its product mix into banking, fashion, ethnic retail, and
pharmacy through organic growth and strategic acquisitions. In 2013, the tragic collapse of a
Bangladesh garment factory building where Loblaw's fashion brand Joe Fresh items were
manufactured shocked Canadians and heightened public scrutiny of the company's level of corporate
social responsibility. Later in 2013, Loblaw spun off its real estate investment trust (REIT), which is a
form of income trust. The Loblaw story touches on different forms of business, financial
management, corporate control, and corporate social responsibility, all topics that are discussed in this
chapter.
LEARNING OBJECTIVES
After studying this chapter, you should understand:
1. LO1 The basic types of financial management decisions and the role of the financial manager.
2. LO2 The financial implications of the different forms of business organization.
3. LO3 The goal of financial management.
4. LO4 The conflicts of interest that can arise between managers and owners.
5. LO5 The roles of financial institutions and markets.
Page 2
To begin our study of modern corporate finance and financial management, we need to address two
central issues. First, what is corporate finance, and what is the role of the financial manager in the
corporation? Second, what is the goal of financial management? To describe the financial
management environment, we look at the corporate form of organization and discuss some conflicts
that can arise within the corporation. We also take a brief look at financial institutions and financial
markets in Canada.
1.1 | Corporate Finance and the Financial Manager
In this section, we discuss where the financial manager fits in the corporation. We start by looking at
what corporate finance is and what the financial manager does.
What Is Corporate Finance?
Imagine that you were to start your own business. No matter what type you started, you would have to
answer the following three questions in some form or another:
1. What long-term investments should you take on? That is, what lines of business will you be in
and what sorts of buildings, machinery, equipment, and research and development facilities will
you need?
2. Where will you get the long-term financing to pay for your investment? Will you bring in other
owners or will you borrow the money?
3. How will you manage your everyday financial activities, such as collecting from customers and
paying suppliers?
These are not the only questions by any means, but they are among the most important. Corporate
finance, broadly speaking, is the study of ways to answer these three questions.
Accordingly, we'll be looking at each of them in the chapters ahead. Though our discussion focuses
on the role of the financial manager, these three questions are important to managers in all areas of the
corporation. For example, selecting the firm's lines of business (Question 1) shapes the jobs of
managers in production, marketing, and management information systems. As a result, most large
corporations centralize their finance function and use it to measure performance in other areas. Most
CEOs have significant financial management experience.
The Financial Manager
A striking feature of large corporations is that the owners (the shareholders) are usually not directly
involved in making business decisions, particularly on a day-to-day basis. Instead, the corporation
employs managers to represent the owners' interests and make decisions on their behalf. In a large
corporation, the financial manager is in charge of answering the three questions we raised earlier.
For current issues facing CFOs, seecfo.com
It is a challenging task because changes in the firm's operations, and shifts in Canadian and global
financial markets, mean that the best answers for each firm are changing, sometimes quite rapidly.
Globalization of markets, advanced communications and computer technology, and increased
volatility of interest rates and foreign exchange rates have raised the stakes in financial management
decisions. We discuss these major trends and how they are changing the financial manager's job after
we introduce you to some of the basics of corporate financial decisions.
Page 3
The financial management function is usually associated with a top officer of the firm, such as a vice
president of finance or some other chief financial officer (CFO). Figure 1.1 is a simplified
organization chart that highlights the finance activity in a large firm. The CFO reports to the
president, who is the chief operating officer (COO) in charge of day-to-day operations. The COO
reports to the chairman, who is usually CEO. However, as businesses become more complex, there is
a growing pattern among large companies to separate the roles of chairman and CEO. The CEO has
overall responsibility to the board. As shown, the vice president of finance coordinates the activities
of the treasurer and the controller. The controller's office handles cost and financial accounting, tax
payments, and management information systems. The treasurer's office is responsible for managing
the firm's cash, its financial planning, and its capital expenditures. These treasury activities are all
related to the three general questions raised earlier, and the chapters ahead deal primarily with these
issues. Our study thus bears mostly on activities usually associated with the treasurer's office.
Click here for a description of Figure 1.1: A Simplified Organization Chart.
FIGURE 1.1
FIGURE 1.1A simplified organization chart. The exact titles and organization differ from company to
company.
Financial Management Decisions
As our discussion suggests, the financial manager must be concerned with three basic types of
questions. We consider these in greater detail next.
Page 4
CAPITAL BUDGETING The first question concerns the firm's long-term investments. The process
of planning and managing a firm's long-term investments is called capital budgeting. In capital
budgeting, the financial manager tries to identify investment opportunities that are worth more to the
firm than they will cost to acquire. Loosely speaking, this means that the value of the cash flow
generated by an asset exceeds the cost of that asset. The types of investment opportunities that would
typically be considered depend in part on the nature of the firm's business. For example, for a retailer
like Loblaw, deciding whether or not to open stores would be a major capital budgeting decision.
Some decisions, such as what type of computer system to purchase, might not depend so much on a
particular line of business.
Financial managers must be concerned not only with how much cash they expect to receive, but also
with when they expect to receive it and how likely they are to receive it. Evaluating the size, timing,
and risk of future cash flows is the essence of capital budgeting. We discuss how to do this in detail in
the chapters ahead.
CAPITAL STRUCTURE The second major question for the financial manager concerns how the firm
should obtain and manage the long-term financing it needs to support its long-term investments. A
firm's capital structure (or financial structure) refers to the specific mixture of short-term debt, long-
term debt, and equity the firm uses to finance its operations. The financial manager has two concerns
in this area. First, how much should the firm borrow; that is, what mixture is best? The mixture
chosen affects both the risk and value of the firm. Second, what are the least expensive sources of
funds for the firm?
If we picture the firm as a pie, then the firm's capital structure determines how that pie is sliced. In
other words, what percentage of the firm's cash flow goes to creditors and what percentage goes to
shareholders? Management has a great deal of flexibility in choosing a firm's financial structure.
Whether one structure is better than any other for a particular firm is the heart of the capital structure
issue.
In addition to deciding on the financing mix, the financial manager has to decide exactly how and
where to raise the money. The expenses associated with raising long-term financing can be
considerable, so different possibilities must be carefully evaluated. Also, corporations borrow money
from a variety of lenders, tapping into both Canadian and international debt markets, in a number of
different—and sometimes exotic—ways. Choosing among lenders and among loan types is another of
the jobs handled by the financial manager.
WORKING CAPITAL MANAGEMENT The third major question concerns working capital
management. The phrase working capital refers to the difference between a firm's short-term assets,
such as inventory, and its short-term liabilities, such as money owed to suppliers. Managing the firm's
working capital is a day-to-day activity that ensures the firm has sufficient resources to continue its
operations and avoid costly interruptions. This involves a number of activities, all related to the firm's
receipt and disbursement of cash.
Page 5
Some of the questions about working capital that must be answered are as follow. (1) How much cash
and inventory should we keep on hand? (2) Should we sell on credit? If so, what terms should we
offer, and to whom should we extend them? (3) How do we obtain any needed short-term financing?
Will we purchase on credit or borrow short-term and pay cash? If we borrow short-term, how and
when should we do it? This is just a small sample of the issues that arise in managing a firm's working
capital.
The three areas of corporate financial management we have described—capital budgeting, capital
structure, and working capital management—are very broad categories. Each includes a rich variety
of topics; we have indicated only a few of the questions that arise in the different areas. The following
chapters contain greater detail.
Concept Questions
1. What is the capital budgeting decision?
2. Into what category of financial management does cash management fall?
3. What do you call the specific mixture of short-term debt, long-term debt, and equity that a firm
chooses to use?
1.2 | Forms of Business Organization
Large firms in Canada, such as CIBC and BCE, are almost all organized as corporations. We examine
the five different legal forms of business organization—sole proprietorship, partnership, corporation,
income trust, and co-operative—to see why this is so. Each of the three forms has distinct advantages
and disadvantages in the life of the business, the ability of the business to raise cash, and taxes. A key
observation is that, as a firm grows, the advantages of the corporate form may come to outweigh the
disadvantages.
Sole Proprietorship
A sole proprietorship is a business owned by one person. This is the simplest type of business to
start and is the least regulated form of organization. Depending on where you live, you can start up a
proprietorship by doing little more than getting a business licence and opening your doors. For this
reason, many businesses that later become large corporations start out as sole proprietorships. There
are more proprietorships than any other type of business.
As the owner of a sole proprietorship, you keep all the profits. That is the good news. The bad news is
that the owner has unlimited liability for business debts. This means that creditors can look beyond
assets to the proprietor's personal assets for payment. Similarly, there is no distinction between
personal and business income, so all business income is taxed as personal income.
Page 6
For more information on forms of business organization, see the “Starting a Business” section
at canadianlawsite.ca; also seecanadabusiness.ca
The life of a sole proprietorship is limited to the owner's life span, and, importantly, the amount of
equity that can be raised is limited to the proprietor's personal wealth. This limitation often means that
the business cannot exploit new opportunities because of insufficient capital. Ownership of a sole
proprietorship may be difficult to transfer, since this requires the sale of the entire business to a new
owner.
Partnership
A partnership is similar to a proprietorship, except that there are two or more owners (partners). In a
general partnership, all the partners share in gains or losses, and all have unlimited liability for all
partnership debts, not just some particular share. The way partnership gains (and losses) are divided is
described in the partnership agreement. This agreement can be an informal oral agreement or a
lengthy, formal written document.
In a limited partnership, one or more general partners has unlimited liability and runs the business for
one or more limited partners who do not actively participate in the business. A limited partner's
liability for business debts is limited to the amount contributed to the partnership. This form of
organization is common in real estate ventures, for example.
The advantages and disadvantages of a partnership are basically the same as those for a
proprietorship. Partnerships based on a relatively informal agreement are easy and inexpensive to
form. General partners have unlimited liability for partnership debts, and the partnership terminates
when a general partner wishes to sell out or dies. All income is taxed as personal income to the
partners, and the amount of equity that can be raised is limited to the partners' combined wealth.
Ownership by a general partner is not easily transferred because a new partnership must be formed. A
limited partner's interest can be sold without dissolving the partnership. But finding a buyer may be
difficult because there is no organized market in limited partnerships.
Based on our discussion, the primary disadvantages of sole proprietorship and partnership as forms of
business organization are (1) unlimited liability for business debts on the part of the owners, (2)
limited life of the business, and (3) difficulty of transferring ownership. These three disadvantages
add up to a single, central problem—the ability of such businesses to grow can be seriously limited by
an inability to raise cash for investment.
Corporation
In terms of size, the corporation is the most important form of business organization in Canada. A
corporation is a legal entity, separate and distinct from its owners; it has many of the rights, duties,
and privileges of an actual person. Corporations can borrow money and own property, can sue and be
sued, and can enter into contracts. A corporation can even be a general partner or a limited partner in
a partnership, and a corporation can own stock in another corporation.
Page 7
Not surprisingly, starting a corporation is somewhat more complicated than starting the other forms of
business organization, but not greatly so for a small business. Forming a corporation involves
preparing articles of incorporation (or a charter) and a set of bylaws. The articles of incorporation
must contain a number of things, including the corporation's name, its intended life (which can be
forever), its business purpose, and the number of shares that can be issued. This information must be
supplied to regulators in the jurisdiction where the firm is incorporated. Canadian firms can be
incorporated under either the federal Canada Business Corporation Act or provincial law.1
The bylaws are rules describing how the corporation regulates its own existence. For example, the
bylaws describe how directors are elected. These bylaws may be a very simple statement of a few
rules and procedures, or they may be quite extensive for a large corporation. The bylaws may be
amended or extended from time to time by the shareholders.
In a large corporation, the shareholders and the management are usually separate groups. The
shareholders elect the board of directors, which then selects the managers. Management is charged
with running the corporation's affairs in the shareholders' interest. In principle, shareholders control
the corporation because they elect the directors.
As a result of the separation of ownership and management, the corporate form has several
advantages. Ownership (represented by shares of stock) can be readily transferred, and the life of the
corporation is therefore not limited. The corporation borrows money in its own name. As a result, the
shareholders in a corporation have limited liability for corporate debts. The most they can lose is what
they have invested.2
While limited liability makes the corporate form attractive to equity investors, lenders sometimes
view the limited liability feature as a disadvantage. If the borrower experiences financial distress and
is unable to repay its debt, limited liability blocks lenders' access to the owners' personal assets. For
this reason, chartered banks often circumvent limited liability by requiring that owners of small
businesses provide personal guarantees for company debt.
The relative ease of transferring ownership, the limited liability for business debts, and the unlimited
life of the business are the reasons why the corporate form is superior when it comes to raising cash.
If a corporation needs new equity, for example, it can sell new shares of stock and attract new
investors. The number of owners can be huge; larger corporations have many thousands or even
millions of shareholders.
The corporate form has a significant disadvantage. Because a corporation is a legal entity, it must pay
taxes. Moreover, money paid out to shareholders in dividends is taxed again as income to those
shareholders. This is double taxation, meaning that corporate profits are taxed twice—at the corporate
level when they are earned, and again at the personal level when they are paid out.3
As the discussion in this section illustrates, the need of large businesses for outside investors and
creditors is such that the corporate form generally is best for such firms. We focus on corporations in
the chapters ahead because of the importance of the corporate form in the Canadian and world
economies. Also, a few important financial management issues, such as dividend policy, are unique to
corporations. However, businesses of all types and sizes need financial management, so the majority
of the subjects we discuss bear on all forms of business.
A CORPORATION BY ANOTHER NAME The corporate form of organization has many variations
around the world. The exact laws and regulations differ from country to country, of course, but the
essential features of public ownership and limited liability remain. These firms are often designated as
joint stock companies, public limited companies, or limited liability companies, depending on the
specific nature of the firm and the country of origin.
Page 8
In addition to international variations, there are specialized forms of corporations in Canada and the
U.S. One increasingly common example is the professional corporation set up by architects,
accountants, lawyers, dentists, and others who are licensed by a professional governing body. A
professional corporation has limited liability but each professional is still open to being sued for
malpractice.
Income Trust
Starting in 2001, the income trust, a non-corporate form of business organization, grew in importance
in Canada.4 In response to the growing importance of this sector, provincial legislation extended
limited liability protection, previously limited to corporate shareholders, to trust unit holders. Along
the same lines, at the end of 2005, the TSX began to include income trusts in its benchmark S&P /
TSX Composite Index.
Business income trusts (also called income funds) hold the debt and equity of an underlying business
and distribute the income generated to unit holders. Because income trusts are not corporations, they
are not subject to corporate income tax and their income is typically taxed only in the hands of unit
holders. As a result, investors viewed trusts as tax-efficient and were generally willing to pay more for
a company after it converted from a corporation to a trust. However, this tax advantage largely
disappeared on Halloween 2006 when the government announced plans to tax income trusts, except
REITs, at the same rate as corporations starting in 2011. As a result, most income trusts converted to
corporations. The number of income trusts reduced from 179 (with a market capitalization of $112.1
billion) in 2009 to 65 (with a market capitalization of $51.5 billion) in mid-2011. As of September